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Question
Your friend Ricky took a finance class and learned about the risk-return trade-off. Wanting a high return, Ricky invested in a risky, start-up technology company. A year later the company went bankrupt and Ricky lost his entire investment. Ricky is furious with his finance professor for misleading him, claiming he was taught that higher return goes with higher risk. Explain how Ricky misinterpreted the risk-return trade-off.Answer
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Related questions
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The firm's total investment in current assets should be financed with temporary sources of financing.
Q:
The hedging principle involves the use of hedge funds to manage the firm's working capital.
Q:
How does the use of current liabilities enhance profitability and also increase the firm's risk of default on its financial obligations?
Q:
Current assets would usually NOT include
A) plant and equipment.
B) marketable securities.
C) accounts receivable.
D) inventories.
Q:
A firm increases the risks of insolvency by keeping relatively large amounts of money tied up in marketable securities.
Q:
Management of a firm's liquidity involves management of the firm's investment in current assets as well as its mix of long-term capital.
Q:
Symco Corp. needs $500,000 for 90 days to get through a period of unexpectedly high oil prices. Symco's line of credit with the bank allows the company to borrow at 6% per year with a compensating balance of 10% of the amount borrowed. Currently, Symco has no money on deposit with the bank.
a. Calculate the amount Symco must borrow to meets its needs plus the compensating balance.
b. What is the annual percentage rate for this financing?
c. If the bank requires discount interest, what is the annual percentage rate for this financing?
Q:
Dazzly Diamond Corp. called for credit at the Home Alone Bank of Paris, TX. The terms included a $35,000 maximum loan with interest of 1 percent over prime, and the agreement also requires a 15% compensating balance throughout the year. The prime rate is currently 12 percent.
a. If Dazzly Diamond Corp. maintains a balance in its account of $5,250 to $6,000, what is the effective cost of credit through the line-of-credit agreement where the maximum amount of the loan is used?
b. Recompute the effective cost of credit to Dazzly Diamond if it will have to borrow the compensating balance and the maximum amount possible under the agreement.
Q:
Crenshaw Inc. has a $400,000 line of credit with a local bank. The bank requires a compensating balance of 10% of the loan and extends credit to Crenshaw at 1% over the current prime rate. Crenshaw needs the use of $200,000 for the three-month period. They currently have no deposits with the lending bank.
a. What will the effective annual cost of this credit be? (Assume a 360-day year and a 9% prime rate.)
b. Using the above information, what would be the effective interest rate if the firm discounted the interest on the loan?
Q:
MovieTone, Inc. is a producer and distributor of specialty DVDs. It sells directly to large retail firms on terms of net 60 and has average monthly sales of $350,000. It has recently decided to pledge all of its accounts receivable to its bank. The bank advances up to 80 percent of the face value of these receivables at a rate of 4 percent over the prime rate, while charging 2.5 percent on all receivables pledged for processing to cover billing and collection services. Prior to this arrangement MovieTone was spending $50,000 a year on its credit department. The prime rate is 6 percent.
a. What is the average level of accounts receivable?
b. What is the effective cost of using this short-term credit for one year?
Q:
The Rosewood Corporation established a line of credit with a local bank. The maximum amount that can be borrowed under the terms of the agreement is $500,000 at a rate of 10 percent. A compensating balance averaging 15 percent of the loan is required. Prior to the agreement, Rosewood had maintained an account at the bank averaging $25,000. Any additional funds needed for the compensating balance will also have to be borrowed at the 10 percent rate. If the firm needs $280,000 for 6 months, what is the annual cost of the loan?
Q:
A company that has an unpredictable cash flow, and is holding cash because of things that might happen due to this uncertainty, is holding a larger minimum cash balance due to which type of motive?
A) transaction
B) precautionary
C) speculative
D) common sense
Q:
Which of the following affects the precautionary motive for holding cash?
A) the cash flow predictability
B) the firm's access to external funds
C) both A and B
D) none of the above
Q:
John Maynard Keynes segmented a firm's demand for cash into the following motives:
A) risk, investment, and liquidity.
B) transaction, speculative and precautionary.
C) transaction, liquidity, and speculative.
D) transaction, speculative, and risky.
Q:
Cash inflows come from
A) purchase of marketable securities.
B) purchase of fixed assets.
C) credit sales.
D) cash sales.
Q:
The speed of the collections process is determined by three types of float: mail float, processing float, and transit float.
Q:
Money-market mutual funds are diversified portfolios of short-term, high-grade debt instruments.
Q:
Marketable securities are only those security investments the firm can convert into cash balances within one year.
Q:
An extremely liquid asset is one that can be sold for cash quickly without a reduction in price below its current market value.
Q:
Exchange rate risk is highest for companies with
A) international trade contracts denominated in the foreign currency.
B) investment portfolios that contain foreign securities.
C) direct foreign investments in foreign subsidiaries.
D) international trade contracts denominated in the domestic currency.
Q:
Exchange rate risk exists in International Trade Contracts, Foreign Portfolio Investments, and in Direct Foreign Investments.
Q:
Exchange-rate risk arises from the fact that the spot exchange rate on a future date is unknown today.
Q:
Exchange rate risk exists for a party to a contract if the contract is denominated in a foreign currency.
Q:
Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $18,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the tax effect of selling the old machine?
A) a savings of $2,800
B) a savings of $2,450
C) additional taxes paid of $2,450
D) a tax savings of $1,400
Q:
An asset with an original cost of $100,000 and a current book value of $20,000 is sold for $50,000 as part of a capital budgeting project. The company has a tax rate of 30%. This transaction will have what impact on the project's initial outlay?
A) reduce it by $20,000
B) reduce it by $50,000
C) reduce it by $6,000
D) reduce it by $15,000
Q:
A new machine can be purchased for $1,200,000. It will cost $35,000 to ship and $15,000 to modify the machine. A $12,000 recently completed feasibility study indicated that the firm can employ an existing factory owned by the firm, which would have otherwise been sold for $180,000. The firm will borrow $750,000 to finance the acquisition. Total interest expense for 5-years is expected to approximate $350,000. What is the investment cost of the machine for capital budgeting purposes?
A) $2,180,000
B) $1,780,000
C) $1,442,000
D) $1,430,000
Q:
J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years. Which of the following statements concerning the change in working capital is MOST accurate?
A) The $4,000 paid for oil is added to the initial outlay, offset by the tax savings $1600.
B) The $4,000 may be expensed each year over the life of the project as part of the incremental free cash flows.
C) The $4,000 is added to the initial outlay and recaptured during the terminal year, hence having no impact on the projects NPV or IRR.
D) Even if the $4,000 is fully recovered at the end of the project, the project's NPV and IRR will be lower if the change in working capital is included in the analysis.
Q:
Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $18,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the incremental free cash flow for year one?
A) $18,875
B) $19,985
C) $22,305
D) $24,220
Q:
A new project is expected to generate $800,000 in revenues, $250,000 in cash operating expenses, and depreciation expense of $150,000 in each year of its 10-year life. The corporation's tax rate is 35%. The project will require an increase in net working capital of $85,000 in year one and a decrease in net working capital of $75,000 in year ten. What is the free cash flow from the project in year one?
A) $298,000
B) $375,000
C) $380,000
D) $410,000
Q:
You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp. of America. The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $28,000. Use of the equipment will require an increase in your company's net working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs. Your company's marginal tax rate is 35%. What is the initial outlay required to fund this project?
A) $80,000
B) $84,000
C) $90,000
D) $94,000